Regulation of Financial Markets

Transcription

1 Chapter 5 Regulation of Financial Markets Introduction 5.1 This chapter considers the regulation and development of Australian financial markets in the light of the Inquiry s Terms of Reference that direct it to propose regulatory arrangements that: best promote the most efficient and cost effective service for users, consistent with financial market stability, prudence, integrity and fairness; and ensure that financial system providers are well placed to develop technology, services and markets and that the financial system regulatory regime is adaptable to such innovation. 5.2 The financial markets play a critical role in raising and allocating capital, providing avenues of investment, facilitating risk management, providing liquidity and facilitating international trade. Internationally competitive, efficient and liquid financial markets are therefore vital to Australia s economic well-being. 5.3 The chapter addresses 3 main issues: ¾first, whether arrangements for regulating financial market integrity facilitate the development of internationally competitive and innovative markets; ¾secondly, the development of efficient and liquid financial markets, in particular whether there are any impediments to the process of securitisation or secondary trading of financial instruments; and ¾finally, the effectiveness of the financial markets in providing debt and equity capital to small and medium sized enterprises (SMEs)

2 Financial System Inquiry 5.4 Other issues relating to the competitiveness of Australian financial markets and measures to promote Australia as a regional financial centre are considered in Chapter The financial markets considered in this chapter have been defined very broadly. They encompass markets for debt, equities and foreign exchange, which can be further divided into: ¾primary markets where financial instruments such as bonds, shares and trust units are initially issued to raise capital; ¾secondary markets where financial instruments are priced and traded; and ¾derivatives markets involving futures or other contracts whose value is derived from a separate underlying asset, rate or index. 5.6 These markets may be classified as being conducted: ¾on approved exchanges primarily the Australian Stock Exchange (ASX) and the Sydney Futures Exchange (SFE); ¾in over the counter (OTC) markets conducted on a bilateral basis principally between wholesale market participants; or ¾in retail markets between financial institutions and their customers. Market Integrity Regulation 5.7 Market integrity regulation refers to the legislative and self-regulatory arrangements which aim to ensure that markets are efficient, orderly and fair. Such regulation aims to improve the efficiency of financial markets in pricing, allocating capital, managing risk and avoiding fraud. From an economic perspective, market integrity rules fall into two broad categories: ¾disclosure rules which attempt to address information gaps so that investors take appropriate risks on the basis of good quality information (eg prospectus requirements for fundraising, financial reporting rules and accounting standards); and

3 Chapter 5: Regulation of Financial Markets ¾conduct rules which aim to promote orderly and efficient price discovery, trading and settlement (eg rules applying to the approval and oversight of exchanges and their members, and legal prohibitions on unfair trading and market manipulation). 5.8 Market integrity is often seen as a factor in promoting investor confidence and attracting foreign investment. At the same time, regulation imposes costs and restrictions on market participants. Consequently, there is a balance to be struck between setting high market integrity standards and imposing excessive costs or unnecessary activity restrictions that hamper the competitiveness and efficiency of Australian financial markets. 5.9 While this chapter is concerned with market integrity rather than prudential regulation, there is an important link between the two since market integrity can reduce systemic risk. Financial disturbances are more likely to be contained where financial markets are underpinned by good information, a sound legal framework and robust settlement systems (see Chapter 4 for a discussion on systemic risk.) Existing Arrangements 5.10 The existing scheme of market integrity regulation in Australia includes a mix of government regulation, co-regulation and self-regulation as shown in Tables 5.1 and 5.2. Australian Securities Commission and the Corporations Law 5.11 Financial market integrity in Australia is primarily regulated by the Australian Securities Commission (ASC) under the Corporations Law. The Corporations Law is a national scheme based on a 1990 agreement between the Commonwealth, States and Northern Territory. Under the Corporations Law, the ASC takes a direct role in registering prospectuses, licensing securities dealers and futures brokers, monitoring financial markets and enforcing market integrity rules. The ASC is also responsible for licensing investment and futures advisers (see Chapter 8) and for general company regulation

4 Table 5.1: Australian Wholesale Markets: Disclosure Regulation Regulatory field Government legislation & oversight Co-regulation Self-regulation Issues of securities Company annual reports Corporations Law ASC registration of prospectuses financial reporting rules prohibition on false & misleading statements Trade Practices Act prohibition on false & misleading statements Corporations Law financial reporting rules Approved exchanges ASX listing rules Approved exchanges ASX listing rules n.a. n.a

5 Financial System Inquiry Table 5.2: Australian Wholesale Markets: Conduct Regulation Regulatory field Government legislation & oversight Co-regulation Self-regulation Securities, Futures and Options Exchanges OTC Financial Markets Securities & Futures Clearing & Settlement Professional Market Participants Corporations Law Treasurer s approval to conduct an exchange, amend market rules ASC enforcement of market manipulation prohibitions Trade Practices Act ACCC approval of anti-competitive arrangements Corporations Law Treasurer s approval to conduct exempt stock and futures markets ASC enforcement of market manipulation prohibitions Reserve Bank RITS Corporations Law ASC securities dealers & futures brokers registration Banking (Foreign Exchange) Regulations Reserve Bank registration of foreign exchange dealers Approved exchanges business/listing rules surveillance of members and trading obligation to report wrongdoing to the ASC Australian Investment Management Association corporate governance Code of Ethics & practice notes standard management contracts n.a. Australian Financial Markets Association Authorised exchanges CHESS SFE Clearing House Authorised exchange members ASX members SFE floor, associate and local members voluntary code of conduct and market conventions Aussie ISDA swaps & derivatives documentation Private clearing/settlement Austraclear BITS Australian Financial Markets Association OTC market participants

6 5.12 Two other bodies formed under the Corporations Scheme have direct relevance to financial market integrity. Members of both bodies are appointed by the Treasurer. ¾The Companies and Securities Advisory Committee (CASAC) advises on Corporations Scheme laws and market developments. Of relevance to the Inquiry is CASAC s recent work on regulating derivatives. 1 ¾The Australian Accounting Standards Board is charged with developing a conceptual framework for accounting standards and reviewing proposed standards Chapter 7 of the Corporations Law deals with securities, and Chapter 8 sets out similar but not identical provisions for futures contracts. Broadly, securities and futures must be traded by licensed intermediaries on exchanges which have been approved by the Treasurer. Securities and futures markets may be conducted outside exchanges only where they are specifically exempted in the Corporations Law or the Treasurer has declared an exempt market. (See later discussion on OTC markets.) 5.14 While the Corporations Law treatment of securities is broadly similar to that of futures contracts, there are a number of key differences: ¾prospectuses are required for issues of securities, but not for futures contracts; ¾securities dealers may conduct transactions off-exchange (ASX listing rules impose some limits), whereas generally futures brokers may not deal off-exchange; and ¾securities advisers have specific obligations to disclose commissions and have a reasonable basis for securities recommendations (the know your client rule). There are no equivalent provisions for futures advisers. 1 Companies and Securities Advisory Committee 1996, and

7 Financial System Inquiry Australian Competition and Consumer Commission 5.15 The Australian Competition and Consumer Commission (ACCC) has a role promoting market integrity under the Trade Practices Act 1974 (TPA) provisions which: ¾prohibit misleading or deceptive conduct (s.52); and ¾give the ACCC power to authorise arrangements which might otherwise be considered anti-competitive (s.88). Co-regulation of On-Exchange Financial Markets 5.16 The Corporations Law takes a co-regulatory approach to exchanges. 2 The Treasurer s approval is required to conduct an exchange, and the Treasurer has power to disallow amendments to its business or listing rules. Aspects of an exchange s business can also require authorisation by the ACCC under s.88 of the TPA. ASC surveillance and enforcement programmes cover the conduct of both exchange trading and exchange members. However, approved exchanges are responsible for their day to day management and supervision of members There are two major approved exchanges currently operating in Australia The ASX ranks tenth in the world, with its domestic market capitalisation of $347 billion. It represents around 1.6 per cent of the Morgan Stanley Capital International Index. 3 Turnover on the ASX was less than one per cent of the total turnover in Australian financial markets in The ASX operates a national electronic order-driven market in Australian equities, foreign equities and options called the Stock Exchange Automated Trading System (SEATS). It also operates the Clearing House Electronic Sub-register System (CHESS) for exchange-quoted securities. In addition, the ASX owns the Securities Exchanges Guarantee Corporation, which operates a 2 While the ASX and the SFE are frequently called self-regulatory organisations, the framework is actually a co-regulatory combination of government approvals and oversight plus exchange rules and surveillance. 3 Australian Stock Exchange, Submission No. 65 to the Financial System Inquiry, p.7. 4 Securities Industry Research Centre of Asia-Pacific 1996, p

8 Chapter 5: Regulation of Financial Markets National Guarantee Fund to guarantee completion of contracts in the event of default by a member firm. ASX members voted to demutualise the exchange in October The SFE originally traded commodity futures, but financial futures and options have become a major part of its business in the past decade. The SFE is the thirteenth largest futures market in the world, with a nominal annual turnover of $6.8 trillion in Turnover on the SFE represented 28 per cent of the total Australian financial market turnover in The SFE owns the Sydney Futures Exchange Clearing House, which guarantees the completion of SFE futures and options contracts and operates an indemnity fund. Self-Regulation of OTC Markets 5.20 OTC markets represented over 70 per cent of Australian financial market turnover in These markets fall into two categories: ¾exempt securities or futures markets under the Corporations Law, the Treasurer may declare exempt securities and futures markets. This declaration exempts these markets from the general rule that securities and futures must be traded on approved exchanges. Other Corporations Law rules such as those prohibiting market manipulation and insider trading continue to apply. Exempt markets have been declared for such diverse products as public sector bonds and the New South Wales Electricity Swap Market. ¾other OTC markets which are not subject to the Corporations Law because they fall outside the legal definition of a security or futures contract. These include markets for foreign exchange and certain derivatives where one party is a bank. 5 Sydney Futures Exchange Yearbook 1995, p Securities Industry Research Centre of Asia-Pacific 1996, p Securities Industry Research Centre of Asia-Pacific 1996, p

9 Financial System Inquiry 5.21 Self-regulatory initiatives play an important role in promoting market integrity in OTC markets. Steps taken by the Australian Financial Markets Association (AFMA) to promote market integrity and consistency with international practices are outlined in Table While OTC transactions can be settled bilaterally, many OTC transactions are cleared and settled through the Reserve Bank Information and Transfer System (RITS), the Bank Interchange and Transfer System (BITS) and Austraclear. Corporations Law Simplification Task Force: Fundraising 5.23 Under the Corporations Law, a prospectus is generally required for company fundraisings (initial public offers and rights issues) and continuous offers (such as debentures and trust units). However, a prospectus is not required for: ¾small-scale private offers where a company makes up to 20 personal offers of securities in a rolling one-year period; or ¾individual offers over $500,000. This exclusion is aimed at sophisticated investors who are considered to have sufficient resources and bargaining power to evaluate investments without a formal prospectus requirement The Corporations Law Simplification Task Force is reviewing fundraising requirements, including matters such as short-form prospectuses and civil liability for statements made in prospectuses. The Task Force is also reviewing the interaction between the Corporations Law and the TPA, which apply to fundraising documents in different ways. 8 ¾The Corporations Law sets out a positive duty to issue a prospectus containing all such information as investors and their professional advisers would reasonably require and reasonably expect to find in a prospectus. The law imposes civil liability for false or misleading 8 Corporations Law Simplification Task Force

10 Chapter 5: Regulation of Financial Markets statements and omissions, but allows a defence for persons who have made reasonable inquiries or exercised due diligence. 9 ¾Section 52 of the TPA is a general provision prohibiting misleading and deceptive conduct in trade or commerce. The TPA does not impose a duty to disclose, and no due diligence defence is available for misstatements or omissions. International Co-operation 5.25 The ASC is a member of the International Organisation of Securities Commissions (IOSCO), which aims to promote mutual assistance and high regulatory standards, especially for international securities transactions The 1995 collapse of Barings as a result of trading on the Singapore futures exchange has been a catalyst for strengthening international co-operation. The result has been two agreements. The first was the 1995 Windsor Declaration by key regulators including the ASC. The second was the 1996 Boca Raton agreement signed by major futures exchanges, options exchanges and regulators including the ASC and SFE. Both agreements focus on increased co-operation, information sharing, customer protection and procedures in the event of major defaults and market emergencies The ASC also seeks to facilitate cross-border corporate activity and financial market trading through harmonisation or mutual recognition. ¾Harmonisation is a process by which the laws in a jurisdiction are amended to conform to the laws of another jurisdiction. ¾Mutual recognition involves recognising the laws of another jurisdiction as adequate for domestic purposes. 9 Sections 1022, 1006 and 1008 of the Corporations Law

11 Financial System Inquiry Views Presented in Submissions 5.28 Market integrity issues raised in submissions fell broadly into four groups: ¾whether the Corporations Law deals adequately with product convergence and provides an appropriate basis for competition between financial markets; ¾the impact of prospectus rules; ¾the impact of regulation on financial market costs and competitiveness; and ¾the regulatory structure for market integrity. Product Convergence and Financial Market Competition 5.29 A number of submissions questioned whether the Corporations Law deals adequately with product innovation which has led to convergence of products traded in both exchange and OTC markets Submissions pointed out that new financial instruments such as equity options and deliverable share futures do not fit neatly within the legal definitions of a security or futures contract under the Corporations Law. In addition, some OTC products fall outside these legal definitions and are not covered by the Corporations Law at all. As a result, there can be considerable legal uncertainty about the treatment of new products Futures contracts are generally regarded as a category of derivative since the contract value is based on some other underlying asset, rate or index. Submissions recognised that the Corporations Law term futures contract is now too narrow as a result of rapid growth in OTC derivatives markets. There was broad support for the concept of extending futures regulation to cover derivatives contracts more generally There are a number of factors which have contributed to separate regulation of securities and futures in Australia. Traditionally, these instruments have been traded on different exchanges. The existing Corporations Law definitions of security and futures contract are based on

12 Chapter 5: Regulation of Financial Markets the traditional view that there are fundamental differences in the roles of securities and futures exchanges This view was supported by the SFE, which said that the unbundling of trading and settlement services is blurring the distinction between exchange and OTC markets. It argued that the wisdom of having different regulatory regimes for physical and derivatives markets would become apparent as this unbundling gathers pace. The SFE claimed that proposals to harmonise regulation of securities and derivatives gloss over significant differences between these products Several submissions opposed this view, arguing that traditional distinctions between securities and derivatives may no longer be appropriate The Department of the Treasury argued that the traditional functional distinction between securities (delivery of title) and derivatives (risk management) is breaking down. It cited equity options and deliverable share futures as examples of derivative transactions which lead to a transfer of title when held to maturity. Treasury proposed replacing the existing definitions with a broader concept of financial instrument which would include securities, units in collective investment schemes, financial and commodity futures contracts, swaps and options. Treasury argued that this would standardise regulation, remove incentives for regulatory arbitrage and promote competition The ASX said that product convergence may make it increasingly difficult to maintain the distinction between securities and derivatives. The ASX argued against a regulatory structure which demarcates products on the basis of risk, product type, or the market on which products are traded. It said that regulation based on these criteria will interfere with competition, result in anomalies for investors and distort economic decision-making Submissions suggested that market trends required a reassessment of the role of traditional exchanges and the appropriate regulation of OTC and exchange markets. 10 Factors which call the existing regulatory framework 10 See for example Department of the Treasury, Submission No. 143 to the Financial System Inquiry, p

13 Financial System Inquiry into question are product convergence, the emergence of electronic markets, increased competition among institutional investors and the globalisation of capital markets Both the ASX and SFE said they faced high levels of regulation compared with competitor markets. The ASX also argued that its price discovery and settlement are not free public goods and that its competitors should not free ride on ASX information. The SFE said it was subject to more intense supervision than OTC markets Finally, several submissions raised the dual regulatory approvals required where financial exchanges establish anti-competitive market rules or arrangements. To date, the ACCC has granted a number of approvals relating to the ASX s articles, business rules, clearing and settlement systems under s.88 of the TPA. The ASC and ASX both suggested that there should be rationalisation of the ACCC s role. The ASX said market rules should be approved by the Treasurer only, while the ASC suggested that it could approve market rules subject to consultation with the ACCC. The ACCC considers that existing arrangements are satisfactory. Prospectus Requirements 5.40 Market participants expressed very strong support for the Corporations Law principle-based approach to prospectus rules However, submissions did argue that the law must facilitate technological advances such as electronic prospectuses and also raised concerns about the application of the TPA to prospectuses Market participants said the overlap between Corporations Law and TPA disclosure rules imposes unnecessary cost and uncertainty, and stressed the importance of allowing a due diligence defence for statements required under the Corporations Law. Bankers Trust Australia, the Commonwealth Bank and others recommended that the TPA cease to apply. This approach has also been proposed by the Corporations Law Simplification Task Force Corporations Law Simplification Task Force 1995, pp

14 Chapter 5: Regulation of Financial Markets In contrast, the ACCC and the Australian Consumers Association said there should be no exemptions or amendments to the TPA. Costs and Competitiveness 5.43 Globalisation of capital flows has increased direct and portfolio investment flows as well as opening up international financial markets to Australian companies Submissions addressing the issue said Australia should work towards adopting international accounting standards. 12 They acknowledged that international accounting standards are not yet fully developed, but said their development should be a high priority. The accounting bodies also strongly supported greater harmonisation of Australian accounting standards with those of the International Accounting Standards Committee and other countries Reflecting the number of federal and state laws governing financial reporting obligations, the Australian Society of Certified Practising Accountants recommended a generic financial reporting Act. It said this could overcome inconsistent financial reporting and auditing obligations, inconsistent application of accounting standards and unnecessarily high financial reporting costs. The Australian Society of Corporate Treasurers and AFMA recommended that there be a convergence with international reporting standards A number of submissions expressed concern that Australian regulatory standards could be set too high and fail to recognise changing market dynamics. AFMA estimated that reporting requirements of OTC financial markets were very expensive, with a collective total cost of 12 See for example National Mutual, Submission No. 32; Australian Stock Exchange, Submission No. 65; International Banks and Securities Association, Submission No. 146 and International Accounting Standards Committee, Submission No. 195 to the Financial System Inquiry. 13 Joint submission from The Institute of Chartered Accountants in Australia and the Australian Society of Certified Practising Accountants, Submission No. 187 to the Financial System Inquiry, p

15 Financial System Inquiry $19.6 million (or 900 person hours per year for each organisation). 14 Survey respondents agreed that reports to different government agencies often contain the same or similar information A common theme in submissions was the view that the growing size and complexity of cross-border financial flows pose major challenges for setting and enforcing regulatory standards. Submissions agreed that Australian regulatory standards should aim to be broadly consistent with international standards. The ASC said: Australia cannot afford to be too far out of line with internationally accepted standards of regulation if our markets are to be recognised or market participants are to gain recognition in other jurisdictions Steps towards international regulatory harmonisation taken by IOSCO were welcomed. However, the limitations of this approach owing to long lead times and negotiations required to reach international agreement were also recognised. Structure for Market Integrity Regulation 5.49 While there was general support for ASC regulation of financial market integrity under the Corporations Law, 16 a number of submissions addressed the organisational arrangements for regulating financial market integrity Several submissions said there were synergies between market integrity and general company regulation which suggested these should be the responsibility of a single agency. The fact that Australia has a single regulator for corporations, securities and futures was viewed as a particular strength. 14 Estimate based on survey results. Australian Financial Markets Association, Submission No. 129 to the Financial System Inquiry, p Australian Securities Commission, Submission No. 60 to the Financial System Inquiry, p The Australian Stock Exchange did, however, suggest that the Australian Securities Commission put more focus on market development and could be downsized by outsourcing non-core activities. It also said the simplification project currently under way was insufficient to reduce the length and inflexibility of the Corporations Law

16 Chapter 5: Regulation of Financial Markets 5.51 A number of submissions said that regulatory arrangements should recognise the links between market integrity and consumer protection, which both aim to influence the conduct of market participants. For example, the ANZ Banking Group suggested that the ASC is well suited to taking a consumer protection role because it has a strong market focus and sound knowledge of the financial industry. Bankers Trust and the ASC also claimed that a combined market integrity and consumer protection regulator would be better placed to balance the interests of business and consumers In contrast, some submissions advocated a separate consumer protection regulator on the basis that this would give greater priority and focus to consumer protection issues (see Chapter 8). Other submissions considered that responsibility for market integrity should be included in the ambit of a prudential regulator or a mega-regulator (see Chapter 10) A large number of submissions said the regulatory framework needs to distinguish between wholesale and retail markets. They stressed that consumer protection of retail markets should not be extended to wholesale markets. While a number of market participants expressed this view, 17 the case was put most strongly by AFMA, which said: The regulation of wholesale participants is severely impacting on the competitiveness of Australia in the international context That said, there was no clear view on the criteria which should be adopted in the regulatory framework to distinguish between wholesale and retail customers. National Australia Bank suggested this should have regard to the monetary size of the transaction, the nature of the risk being faced and the nature of the investor. Other submissions supported simple but arbitrary dollar limits to distinguish between retail and wholesale markets for example, the rules requiring a prospectus for offers under $500, See for example Bankers Trust Australia, Submission No. 136; joint submission from the Australian Investment Managers Association, the Life, Investment and Superannuation Association and the Investment Funds Association, Submission No. 157; and the Australian Mutual Provident Society, Submission No. 97 to the Financial System Inquiry. 18 Australian Financial Markets Association, Submission No. 129 to the Financial System Inquiry, p For example Bankers Trust Australia, Submission No. 136, p

17 Financial System Inquiry Approach of the Inquiry 5.55 The Inquiry intends to examine the regulatory framework and its impact on the international competitiveness of Australian financial markets. In doing so, the Inquiry recognises the need to maintain financial market integrity while striving for international competitiveness The Inquiry will consider how the regulatory arrangements for market integrity might affect the cost of capital for business and the degree of competition and pace of innovation in financial markets The Inquiry recognises measures under way to bring Australian regulatory standards into line with prevailing international practice. Standards which are significantly out of line with international practice can impose unnecessary costs on Australian financial firms and markets. Appropriate mutual recognition and harmonisation of regulatory and accounting standards should promote international competitiveness and appear to enjoy broad support In relation to financial markets and exchanges, the Inquiry intends to examine whether product convergence and the emergence of screen-based markets necessitate a reassessment of the regulatory framework. Key issues for the Inquiry include: ¾whether a regulatory framework focused on product definitions or functions is likely to best facilitate product innovation, regulatory certainty and cost-effective regulation; ¾the roles of approved exchanges and the scope for further competition in trading and price discovery, clearing and settlement; ¾the appropriate level of regulation of OTC and exchange markets; ¾whether licensing of foreign exchange dealers, securities dealers and futures brokers should be maintained; and ¾the role of the Treasurer, the ACCC and the ASC in approving the market rules and operations of financial exchanges In making recommendations on prospectus rules, the Inquiry does not intend to duplicate the review of fundraising provisions by the Corporations Law Simplification Task Force

18 Chapter 5: Regulation of Financial Markets 5.60 Finally, few submissions raised substantive concerns with the current oversight by the ASC. However, there was a widespread disposition towards lighter regulation of wholesale financial markets. In examining the organisational arrangements for regulating market integrity, the Inquiry will consider: ¾the need to ensure that the regulatory framework facilitates efficient and innovative trading in financial markets, while still maintaining market integrity; ¾whether there are particular synergies between regulating market integrity and general company regulation or consumer protection; and ¾how the regulatory framework might distinguish between wholesale and retail market participants and transactions. Development of Financial Markets 5.61 This section considers areas where there may be impediments to the development of efficient and liquid financial markets. ¾The first relates to the development of securitisation the issue of marketable debt securities backed by a portfolio of otherwise illiquid assets. 20 ¾The second relates to the creation and trading of unit trusts including superannuation investments. ¾The third relates to secondary trading of financial instruments more generally. 20 Other usages of the term securitisation which are not commonly adopted in Australia refer to: ¾ on-balance sheet securitisation used in Europe to sell mortgage cash flows, without transferring title; and ¾business borrowers switching from traditional bank loans to commercial paper issued in financial markets (disintermediation)

19 Financial System Inquiry Existing Arrangements Securitisation 5.62 The most common form of securitisation in Australia involves the issue of mortgage-backed securities to fund residential mortgages. However, other assets such as credit card receivables or car leases can be used to issue asset-backed securities Securitisation has been used in Australia as a source of funding for: ¾specialist loan originators; ¾financial institutions removing loans from their balance sheet; and ¾State Government-sponsored housing programmes Securitisation potentially leads to cost savings, better products and higher service standards. ¾In traditional intermediated lending, the lending institution handles all aspects of the intermediation process, including loan origination, credit assessment, administration and funding. Securitisation allows functional specialisation in different aspects of the lending transaction as shown in Table 5.3. ¾Lending institutions are required to hold capital against their loan portfolios because they are highly geared institutions primarily funded by deposits. By transferring loan assets to another class of investor, securitisation can reduce the amount of capital held and may lower the cost of funding the portfolio

20 Chapter 5: Regulation of Financial Markets Table 5.3: Participants in a Typical Securitisation Process Borrowers Loan Originator Loan Manager or Servicer Special Purpose Vehicle Borrow money under a mortgage or other agreement. Securitisation is most viable for a pool of standardised loans such as residential mortgages or credit card receivables with predictable patterns of cash flows. Markets and establishes loans which are sold into a special purpose vehicle. Manages administration, payments and defaults of a loan portfolio. Company or a trust used to isolate the loan portfolio and associated cash flows from the originator. May restructure portfolio cash flows (eg swap transactions to transform floating interest rates paid by borrowers into fixed rates preferred by investors). Arranges any credit enhancement investors rely primarily on loan portfolio cash flows to meet interest and principal payments. This may be supplemented by: credit enhancement from external parties; providing additional collateral (eg placing more loans in the repayment pool than is needed to support contractual payments or setting aside a cash deposit to cover shortfalls in expected payments); or transaction structuring (eg, securities issued in tranches with the senior tier carrying lower default risk than subordinated tranches). Credit/Liquidity Enhancers Warehousing Rating Agencies Investors Issues securities. Mortgage insurers insures the lender for the risk of default by borrowers. Governments or financial institutions provide letters of credit or guarantees on the securities issued. Facility provided by a financial institution to fund originated loans until such time as the portfolio reaches a sufficient size for securities to be issued. Financial institution may also provide management of cash flows. Review the quality of the loan portfolio, loan management, legal documentation and credit enhancement. Assign a rating to securities issued. Buy securities. In some cases, trade securities in the secondary market

21 Financial System Inquiry 5.65 The first large-scale securitisation programmes in Australia were State Government mortgage-backed securities (eg, FANMAC and Victorian Housing Bonds) issued in the 1980s. However, private sector securitisations have grown rapidly in the past three years and now overshadow State Government programmes. Securitised bonds backed by Australian assets totalled $12.4 billion at June This comprised private sector mortgage-backed securities (46 per cent), Government mortgage-backed securities (26 per cent), and other private sector securitisations (28 per cent) The expansion of the securitisation market is closely linked to the emergence of mortgage originators such as Aussie Home Loans and Registered Australian Mortgage Securities (RAMS) Mortgage originators have made a tangible contribution to competition in home lending over the past few years. The extent of this competition is evidenced by their rapid gains in market share and the high proportion of loans which are refinancings of bank loans. To date, most of this gain in market share has been at the expense of banks, particularly in urban areas of New South Wales and Western Australia. 22 According to RAMS, nearly half of the loans written by mortgage originators are refinancings of existing bank mortgages Most of the loans written by mortgage originators are funded through securitisation programmes such as those managed by PUMA Management Limited or RAMS Securitisation has also been used by superannuation funds to enter the home lending market. Securitised bonds backed by home loans made to members of industry superannuation funds were issued for the first time in Banks, building societies and credit unions have also used securitisation to fund loans, and submissions suggested that securitisation may become a more important funding source. 21 Based on unpublished data provided by Standard & Poor s Structured Finance. Data excludes securitisations of financial securities where a portfolio of liquid financial instruments (ie, bonds) are purchased, repackaged and then securitised. In this case, the securitisation transforms an already liquid asset into another liquid form. 22 Australian Association of Permanent Building Societies, Submission No. 43 to the Financial System Inquiry, p

22 Chapter 5: Regulation of Financial Markets 5.70 To date, securitisation issues have been marketed almost exclusively to wholesale investors. Over 70 per cent of securitised bonds currently on issue are backed by mortgages Securitisation has allowed mortgage originators to compete in the home lending market because it provides access to wholesale financial markets, eliminating the need to raise deposits or hold capital. Westpac Banking Corporation suggested other factors which have enabled mortgage lenders to gain market share are: ¾their ability to concentrate on loan origination with the funding being done by other institutions; ¾the impact of technology on their ability to assess credit risk and monitor loans; ¾their ability to use low-cost, flexible delivery channels, such as phone marketing and mobile lending; and ¾the existence of wide margins in home mortgage lending, driven by the cross-subsidisation of other banking services such as transaction accounts and corporate lending Growing size and liquidity in securitised bond markets have reduced securitisation costs. According to the Australian Securitisation Forum, margins on mortgage-backed securities have fallen from 150 basis points to 30 basis points above a market benchmark over the past decade. In essence, investors have repriced securitised bonds relative to other debt securities According to the Reserve Bank of Australia (RBA), the banks initially responded to the competition posed by mortgage originators by redesigning some of their mortgage products and more recently by cutting interest margins. 25 In addition, the Inquiry notes that some banks have now begun to securitise their own mortgages. 23 Based on unpublished data provided by Standard & Poor s Structured Finance. 24 Westpac Banking Corporation, Submission No. 90 to the Financial System Inquiry, p Reserve Bank of Australia Bulletin, June 1996, pp

23 Financial System Inquiry Securitisation: Comparison with Overseas Markets 5.74 Securitisation is relatively new in Australia compared with the United States (where a much larger and wider range of assets have been securitised) and some European markets (where securitised bonds are marketed to retail customers) Securitisation emerged in the United States in the 1970s with Federal Government-sponsored issues of mortgage-backed securities. These bonds now total more than US$1.7 trillion, making them the second largest category of debt securities in the United States after Treasury Bonds. The private securitisation market is also more developed in the United States than in other countries. According to OECD over 55 per cent of residential mortgages are securitised in the United States Securitisation is much less developed in Canada despite a significant programme of government support for mortgages and despite close links to United States financial markets. The OECD attributes this to the Canadian tradition of variable-rate (rather than fixed-rate) mortgages, a comparatively small number of nationwide banks, and a banking system which has been under less strain than in the United States European securitisation markets are also less developed than those in the United States. 28 The United Kingdom is the largest market outside the United States, with securitised assets (principally mortgages) totalling around 19 billion at the end of There are signs that the European market is developing rapidly. In September 1996, NatWest announced a major change in its funding strategy with plans to securitise large corporate loans totalling 3.2 billion. In addition, France and Spain have removed legal impediments to securitisation OECD 1995, p OECD 1995, p Apart from on balance sheet securitisation of residential mortgages or communal bonds which have been sold to retail customers in some European countries for many years. 29 OECD 1995, pp

24 Chapter 5: Regulation of Financial Markets 5.78 There are a number of factors which have led to securitisation developing further in the United States than in other countries. ¾Government guarantees of securities initially attracted investors to the sector. ¾There is a large and well-established pool of institutional investors in the United States which are legally separate from the banking system. Securitisation provides a funding conduit between securities houses and lending institutions. ¾The United States has a large number of local banks with portfolios concentrated in a small geographic area. Securitisation allows these banks to diversify their exposures by selling loans made in the local area and purchasing securities based on loans made elsewhere. ¾Securitisation provides a means for banks to manage interest rate risk. In addition, institutional investors generally prefer long-term debt in the form of fixed-interest bonds. Securitisation issues of fixed-interest bonds may be more feasible where the bonds are backed by fixed-rate mortgages (compared to variable-rate mortgages typical in Australia). ¾The large size of United States financial markets provides economies of scale and pooling of risks. This has facilitated securitisation of a wider range of financial instruments, including car leases, accounts receivable, hire purchase agreements and personal loans. The size of the United States market may also have facilitated the development of securitisation technology and skills. ¾Finally, troubled United States banks and thrift institutions have used securitisation to strengthen their capital positions and/or sell portfolios of impaired loans. Secondary Trading in Unit Trusts 5.79 Like securitisation, illiquid assets can be made more marketable through the process of unitisation. In this case, a pooled investment vehicle issues investors with units representing an indirect interest in the underlying assets of a trust. This also allows investors to diversify their risk by pooling their assets to acquire a wider range of investments

25 Financial System Inquiry 5.80 Many pooled investment vehicles are structured as unit trusts established under a trust deed that provides for both a manager and a trustee. The latter has a common law fiduciary duty to protect the interests of investors and is subject to State trustee legislation. A unit trust (other than a superannuation unit trust) is classified as a prescribed interest under the Corporations Law, which requires that public offers be accompanied by a prospectus Unit trusts may be listed (so that units are traded in a secondary market) or unlisted (where investors may redeem their units and are repaid from the assets of the fund). A number of unlisted property trusts transferred to ASX listing in the early 1990s. However, most public offer investment trusts are unlisted, as shown in Table Table 5.4: Investment Funds Management Industry at September 1996 Unlisted Funds Retail Unlisted Funds Wholesale Listed Funds & Investment Companies No. Assets $m No. Assets $m No. Assets $m Property & mortgage 68 3, , ,200 Equity domestic 104 5, Equity international 60 5, , Fixed interest 43 1, , Cash management 516 8, , Diversified 197 8, , Public offer superannuation & rollover funds , , Other 28 2, , Total 1,509 61, , ,823 Source: Investment Funds Association Redemptions from unlisted property trusts were suspended in At the time, these trusts were experiencing severe liquidity problems as a soft property market made it difficult to dispose of assets to meet a high rate of redemptions. 31 Data represents approximately 90 per cent of the retail funds management industry and 60 per cent of the wholesale funds management industry

26 Chapter 5: Regulation of Financial Markets 5.82 Recent developments in the quotation and trading of unit trusts include the establishment of AUSMAQ, which provides a trading and settlement system for unlisted entities such as unit trusts, securitised bonds and certificates of deposit. 32 Investment Link provides price information on unit trusts, but provides no facilities for trading trust units As shown in Table 5.4, public offer superannuation investments represent around 40 per cent of the managed funds industry. Most superannuation funds are also pooled investment vehicles which are legally constituted as trusts. These funds are regulated under the Superannuation Industry (Supervision) Act 1993 rather than the Corporations Law. Investment in a regulated superannuation fund is subject to a considerable body of legislation, including limitations on: ¾the type of person who may contribute to superannuation broadly, superannuation contributions may be made only by a person in the paid workforce or their employer; ¾initial choice of superannuation fund employers making compulsory contributions for employees may choose the superannuation fund subject to any limitations in industrial awards (there are no constraints on choice of fund by self-employed people); ¾switching to another superannuation fund employees can generally only transfer to another superannuation fund after they leave an employer; and ¾choice of investment strategy superannuation funds are presently permitted, but not obliged, to provide members with a choice of investment strategy (eg growth, capital stable, etc) These restrictions have precluded secondary trading in superannuation fund units. However, the Government has announced intentions to relax these requirements, raising the possibility that secondary trading of superannuation units could be possible in future. The planned introduction of Retirement Saving Accounts held on balance sheet by 32 The sale of AUSMAQ to the National Australia Bank was announced in November This restriction is not relevant to defined benefit superannuation funds where the fund member bears no investment risk

27 Financial System Inquiry financial institutions is likely to add a further dimension to choice and competition in superannuation. Secondary Trading in Other Instruments 5.85 A feature of Australian financial markets is the limited development of secondary trading in long-term financial instruments other than equities and government debt Australian companies have made limited use of borrowing through issues of long-term debt securities. Only 13 per cent of aggregate corporate balance sheets is financed by debt securities. 34 In this respect, Australia differs from other economies, particularly the United States and the United Kingdom, where debt securities represent a sizeable proportion of overall corporate sector funding To the extent that Australian corporates have issued debt securities, they have favoured issues of short-term commercial paper or Eurobonds issued outside Australia. The Australian corporate bond market is relatively small and lacks liquidity. Turnover in corporate bonds represents less than 2 per cent of total secondary bond trading Similarly, the infrastructure bond market is a new and relatively small market in Australia. Private sector involvement in the provision of infrastructure facilities increased in the late 1980s when State Governments introduced formal procedures and controls on this activity. In 1992, the Commonwealth Government introduced tax benefits for private financing of infrastructure through borrowings. The Economic Planning Advisory Commission Private Infrastructure Task Force Report in 1995 noted that private sector infrastructure now accounts for 20 per cent of new infrastructure projects. 36 Since 1995, Invest Australia has certified as eligible for tax concessions 14 infrastructure projects with borrowings of $3.5 billion. 34 Westpac Banking Corporation, Submission No. 90 to the Financial System Inquiry, p Reserve Bank of Australia Bulletin, May 1996, p Economic Planning Advisory Commission 1995, p